Many companies lease cars and trucks. This allows them to use late-model vehicles without worrying about disposing of the vehicle a few years down the road. Often auto leases for businesses come with a TRAC (Terminal Rental Adjustment Clause), which specifies that the auto will be sold at the end of the lease; if the auto sells for a lower price than anticipated, the lessee makes up the difference, while if it sells for more, the excess is paid back to the lessee. This means that the lessor essentially has no risk, and is simply providing financing and management of the vehicle. Such a lease will always be a capital (finance) lease, though it can still meet IRS rules to be considered a "true lease," allowing the lessor to retain the tax benefits on the leased asset. However, since lessees usually prefer operating leases, some lessors will adjust the TRAC so that 10.1% of the value of the vehicle is at risk (not covered by the guarantee), which keeps the lease's present value below 90% of the fair value. This is called a "split TRAC" lease.

## Split TRAC lease

Let's take an example of a Ford Focus sedan leased for three years using a split TRAC lease. We'll look at it from the lessee's side of the transaction. The purchase price (fair value) after rebates would be $16,100. The lease calls for payments of $159/month for 36 months. The TRAC clause stipulates a final estimated value of $10,955, of which $9,075 is guaranteed and $1,880 is unguaranteed. Your incremental borrowing rate (the interest rate you would pay to finance a purchase of the car) is 4%.

### FAS 13/IAS 17

Since we know the residual value at the end of the lease, we can calculate the implicit rate, which is 4.108%. The lease is considered operating. Since the rent is the same for the entire life of the lease, there is never any balance sheet impact from the lease. At the end of the lease, when the vehicle is sold, any excess proceeds reimbursed to the lessee are recognized as a gain, while any deficiency payment is an expense.

### ASC 842

The lease is still considered operating, but is capitalized at the present value of the rent plus the expected guaranteed residual payment. If it is expected, at the inception of the lease, that the car will sell for at least the $10,955 estimated value, then only the rent is used for capitalization. If the lessor's initial direct costs are known to be zero, then we use the implicit rate of 4.108% as the discount rate, and the initial right-of-use asset and liability are $6,413; if the initial direct costs are unknown, we use the incremental borrowing rate of 4% as the discount rate, and the ROU asset and liability are $6,423. In either case, the liability and net asset will be the same throughout the life of the lease, amortized using the interest method.

### IFRS 16

Since the lease is neither of a low-value asset nor 12 months or less, it is recognized as a finance lease. The calculated initial ROU asset and liability are the same as for ASC 842. However, during the life of the lease, the asset is depreciated straight-line, while the liability is amortized using the interest method, which will cause the remaining liability always to be larger than the net ROU asset.

## Full TRAC lease

Assume the same conditions as above, except that all of the residual value is guaranteed.

### FAS 13/IAS 17

Since we know the residual value at the end of the lease, we can calculate the implicit rate, which is 4.108%. The lease is considered capital, using 4.108% as the discount rate, with an initial asset and liability of $16,100. At the end of the lease, the liability balance is $10,955; the asset balance depends on whether or not you set up a "salvage value" (an amount of asset that is not depreciated over the life of the lease; you get the smallest gains and losses at termination of a TRAC lease if you set up a salvage value equal to what you expect the proceeds from the vehicle sale to be, but not more than the guaranteed residual). The difference between the asset balance and the sale price of the vehicle is the gain or loss at termination.

### ASC 842/IFRS 16

The lease is finance, and is capitalized at the present value of the rent plus the expected (not maximum) guaranteed residual payment. If it is expected, at the inception of the lease, that the car will sell for at least the $10,955 estimated value, then only the rent is used for capitalization. If the lessor's initial direct costs are known to be zero, then we use the implicit rate of 4.108% as the discount rate, and the initial right-of-use asset and liability are $6,413; if the initial direct costs are unknown, we use the incremental borrowing rate of 4% as the discount rate, and the ROU asset and liability are $6,423. In either case, the liability and net asset will be the same throughout the life of the lease, amortized using the interest method. (This is identical to IFRS 16 split TRAC accounting.)

See our other example pages for more information about how to account for operating and capital/finance leases after they've been set up.